PROF. DAVID SCHREINDORFER FIN 421 - SPRING 2019
Lecture 6 Practice Questions
1. The variance of a portfolio of risky securities is .
A) the sum of the securities’ covariances with the portfolio
B) the sum of the securities’ variances
C) the weighted sum of the securities’ covariances with the porfolio
D) the weighted sum of the securities’ variances
E) none of the above
Answer: C
2. According to the capital asset pricing model, .
A) all securities must lie on the capital market line
B) all securities must lie on the security market line
C) underpriced securities lie below the security market line
D) overpriced securities lie above the security market line
E) all of the above
Answer: B
The SML plots expected returns against betas. All securities should lie on this line. If
a security lies above the line, its expected return is higher than implied by the CAPM,
therefore the security will be underpriced.
3. A security’s beta coefficient will be negative if
A) its returns are negatively correlated with market index returns
B) its returns are positively correlated with market index returns
C) its stock price has historically been very stable
D) its returns have been on average negative for a while
E) market demand for the firm’s shares is very low
Answer: A
Beta is the ratio of covariance to the market variance. Since variances are always
positive, a negative beta is equivalent to a negative correlation.
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, 4. Consider the CAPM. The risk-free rate is 5% and the expected return on the market
is 15%. What is the beta on a stock with an expected return of 12%?
A) .5
B) .7
C) 1.2
D) 1.4
E) None of the above
Answer: B
.12 − .05 = β × (.15 − .05), or β = 0.7
5. The risk-free rate is 4%. The expected market rate of return is 11%. If you expect
stock X with a beta of .8 to offer a rate of return of 12 percent, then according to the
CAPM you should .
A) buy stock X because it is overpriced
B) buy stock X because it is underpriced
C) sell short stock X because it is overpriced
D) sell short stock X because it is underpriced
E) None of the above
Answer: B
.04 + 0.8(.11 − .04) < .12, → α > 0. A positive α means the security is underpriced.
6. Which is NOT a true statement regarding the market portfolio.
A) All securities in the market portfolio are held in proportion to their market
values
B) It includes all assets of the universe
C) It is the tangency point between the capital market line and the indifference
curve
D) It lies on the efficient frontier
E) All are true
Answer: C
The market portfolio is the tangency portfolio, but not every investors indifferent curve
will touch the CML in this point. Investors will combine the market portfolio with the
risk-free asset to find their highest utility.
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Lecture 6 Practice Questions
1. The variance of a portfolio of risky securities is .
A) the sum of the securities’ covariances with the portfolio
B) the sum of the securities’ variances
C) the weighted sum of the securities’ covariances with the porfolio
D) the weighted sum of the securities’ variances
E) none of the above
Answer: C
2. According to the capital asset pricing model, .
A) all securities must lie on the capital market line
B) all securities must lie on the security market line
C) underpriced securities lie below the security market line
D) overpriced securities lie above the security market line
E) all of the above
Answer: B
The SML plots expected returns against betas. All securities should lie on this line. If
a security lies above the line, its expected return is higher than implied by the CAPM,
therefore the security will be underpriced.
3. A security’s beta coefficient will be negative if
A) its returns are negatively correlated with market index returns
B) its returns are positively correlated with market index returns
C) its stock price has historically been very stable
D) its returns have been on average negative for a while
E) market demand for the firm’s shares is very low
Answer: A
Beta is the ratio of covariance to the market variance. Since variances are always
positive, a negative beta is equivalent to a negative correlation.
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, 4. Consider the CAPM. The risk-free rate is 5% and the expected return on the market
is 15%. What is the beta on a stock with an expected return of 12%?
A) .5
B) .7
C) 1.2
D) 1.4
E) None of the above
Answer: B
.12 − .05 = β × (.15 − .05), or β = 0.7
5. The risk-free rate is 4%. The expected market rate of return is 11%. If you expect
stock X with a beta of .8 to offer a rate of return of 12 percent, then according to the
CAPM you should .
A) buy stock X because it is overpriced
B) buy stock X because it is underpriced
C) sell short stock X because it is overpriced
D) sell short stock X because it is underpriced
E) None of the above
Answer: B
.04 + 0.8(.11 − .04) < .12, → α > 0. A positive α means the security is underpriced.
6. Which is NOT a true statement regarding the market portfolio.
A) All securities in the market portfolio are held in proportion to their market
values
B) It includes all assets of the universe
C) It is the tangency point between the capital market line and the indifference
curve
D) It lies on the efficient frontier
E) All are true
Answer: C
The market portfolio is the tangency portfolio, but not every investors indifferent curve
will touch the CML in this point. Investors will combine the market portfolio with the
risk-free asset to find their highest utility.
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